“It is an extra dividend when you like the girl you’ve fallen in love with.” –Clark Gable
If the late great actor is correct, then he found a use for dividends, at least in love. The dividends in your investment portfolio, on the other hand, are quite useless, contrary to popular beliefs.
Those popular beliefs are: that dividends increase returns, and that dividends are a sound income strategy. We’ll debunk both, to prove our assertion.
First, a simple example of how a dividend works, to explain the return issue:
John owns a share of stock in Company A, which is priced at $20, and pays a $1 dividend tomorrow. Bill owns Company B, also priced at $20, but pays no dividend. Tomorrow comes, and Bill still has $20 in stock. John also has just $20, comprised of $1 in cash (from the dividend), and a $19 stock. Why only $19? After the dividend is paid, the market will subtract the amount from the stock price. It’s not free money. John still has only $20, just in a different form. Many people believe that John would end up with a dollar and his original $20 stock. It just doesn’t work that way.
Also, don’t be fooled by any graphs or charts showing that dividend paying stocks outperform those that don’t pay dividends. The academic evidence says that dividends do not result in higher returns. (The explanation is beyond the scope of this article. Call us if you want to know the details.)
Next, we’ll tackle dividends as an income strategy.
The investment world forever changed when, back in the 50’s, Harry Markowitz proved undeniably that diversification works. The majority of stocks in the US do not pay dividends. Nor do 40% of international stocks. To rely on dividends for income means that one must forgo diversification, that pillar of sound investing, and reject half of the entire stock market. It’s better to embrace diversification, and just sell shares when you want cash, rather than wait for a dividend. It’s known as the “total return approach”. It’s the same result mathematically, but with less risk due to the added diversification. Sell, and have less shares at a higher price, or take a dividend and have the same amount of shares but at a lower price. Take the example above. If Bill sold $1 of his non-dividend paying stock, he’d have what John has – $1 in cash and $19 worth of stock.
As a bonus, the total return approach gives you more control over the timing and amount of your income. You can sell anytime, as much as you want. But dividends are paid on a schedule and at a rate determined by the companies, not you.
Let us be clear. Dividends are in no way harmful. Only the myths surrounding them are. And the myth of Sasquatch has more evidence backing its existence than does the myth of a sound dividend strategy. It’s best to leave both stories for the campfire.
Cheers,
John & Bill